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During the past two days, at the Congressional Hearing, Federal Reserve Chairman Ben Bernanke mentioned a few times that the “85-Billion-per-month bond-buy program” has no “present course”. The WSJ commented that “Bernanke’s remarks were his latest attempt to calm markets, which have gyrated wildly since the Fed’s June meeting.”

Why did the markets react negatively to the possibility of reducing the bond-buy program? When the Federal Reserve doesn’t buy the bonds at a low interest rate, the interest rate will go up to meet the regular market demand. The concern is that the result will be more inflation and damage to economic growth. So buying bonds is a subsidy to keep the economy stable. It’s a manipulation to the market stability and in fact it is preventing markets from establishing equilibrium on its own. It ends up creating an inefficient economy. At some point, the Fed has to reduce the subsidy in order to prevent a total market failure.

The Federal Reserve has been spending $85 Billon a month for some time now (a few years) in order to purchase Treasury bonds and other bonds (Fannie Mae, etc.) either in the open market or directly from the issuer (Treasury, etc.). The Federal Reserve keeps the bonds on their balance sheet and the bond issuer spends the money. The Treasury is obligated to pay interest on all the bonds sold until the bonds mature and are redeemed for the original issue price. Without Fed buying, the interest rates would be much higher because there would not be enough buyers at such a low rate of interest.

The Fed now holds over $3.2 Trillion in bonds. See the chart showing the steep increase in the Fed balance sheet in the last few years. The Fed owns more than 90% of home loans in an attempt to save housing. Are you aware of it? What is your thought about Fed bond-buying?


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